Allocation of Indirect Costs Slicing and Dicing for a purpose!

Comparing how costs behave Direct costs Indirect costs Easily traceable to a cost object In manufacturing, direct labor and direct materials are easily traced to one unit of product In a department of a store, department manager salary, cost of goods sold, easily traced to each department Cannot be easily traceable to a cost object In manufacturing, indirect labor, indirect materials, factory costs (utilities, rent, depreciation, property tax, insurance) to one unit of product In a department store, store manager salary (indirect to a single department)

Cost Object is an important starting point! Why are we doing a cost allocation? What is the “object” that we are costing? Examples of a cost object – cost of one unit manufactured, cost of running a department this year, cost of the store for one day, etc. Allocate indirect costs to your cost object – direct costs can be easily traced and do not need allocations

Common Cost terms Cost Driver Cost pool May need several allocations Should have a strong cause and effect relationship to the indirect cost being allocated Manufacturing Examples – direct labor hours, direct labor costs, square footage, machine hours, units produced, etc. Example – cost of indirect labor pool allocated with direct labor costs as the cost driver Service company examples – square footage, revenue, # of employees May need several allocations Group similar indirect costs together that are related Cost pools could include such things as utilities (gas, water, electricity) Assign one appropriate cost driver to that particular cost pool Too many pools may be costly to maintain

Calculating the Allocation rate Estimated indirect costs divided by estimated total cost driver Examples would include calculating cost per direct labor hour (indirect labor cost/total direct labor hours or dollars), cost per square footage (cost of building maintenance/total square footage), etc. For manufacturing, the predetermined overhead rate is an example of an allocation.

Determining the total indirect costs allocated to the cost object Allocation rate times the actual amount of the cost driver Examples Cost object – determine the cost of running department A for a year Utility cost per square feet times the actual square feet in department A Company manager’s salary per employee times the number of employees in department A IT support costs per computer times the number of computers in department A